Inventory Accounting part 7

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Nội dung Text: Inventory Accounting part 7

10 Joint and By-Product Costing1 10-1 Introduction There are many instances where a company will operate a single production process that results in more than one product, none of which can be clearly identified through the early stages of production. Examples of such merged production are in the wood products industry, where a tree can be cut into a wide variety of end prod- ucts, or meat packing, where an animal can be cut into many different finished goods. Up to the point where individual products become clearly identifiable in the production process, there is no clear-cut way to assign costs to products. This issue is of considerable importance to the inventory accountant, who must have a consistent method for assigning costs to these items. We will discuss several cost al- location methods in this chapter that deal with this problem and also note the use- fulness (or lack thereof) of these allocation methods. The key point emphasized by this chapter is that the allocation of costs through any method discussed in this chapter is essentially arbitrary in nature—it results in some sort of cost being assigned to a joint product or by-product, but these costs are only useful for financial or tax reporting purposes, not for management decisions. 10-2 The Nature of Joint Costs To understand joint products and by-products, one must have a firm understanding of the split-off point. This is the last point in a production process where it is impos- sible to determine the nature of the final products. All costs that have been incurred by the production process up until that point—both direct and overhead—must somehow be allocated to the products that result from the split-off point. Any costs incurred thereafter can be charged to specific products in the normal manner. Thus, a product that comes out of such a process will be composed of allocated costs from 1 Adapted with permission from Chapter 15 of Bragg, Cost Accounting: A Comprehensive Guide, John Wiley & Sons, 2001. 141
142 / Inventory Accounting before the split-off point and costs that can be directly traced to it, which occur after the split-off point. A related term is the by-product, which is one or more additional products that arise from a production process, but whose potential sales value is much smaller than that of the principal joint products that arise from the same process. As we will see, the accounting for by-products can be somewhat different. A complication to the joint cost concept is that there can be more than one split- off point. As noted in Exhibit 10-1, we see the processing in a slaughterhouse, where the viscera are removed early in the process, creating a by-product. This is the first split-off point. Then the ribs are split away from the carcass, which is a second split- off point. The ribs may in turn be packaged and sold off at once, or processed fur- ther to produce additional products, such as prepackaged barbequed ribs. In this instance, some costs incurred through the first split-off point may be assigned to the by-product viscera (more on that later), while costs incurred between the first and second split-off points will no longer be assigned to the viscera, but must in turn be assigned to the remaining products that can be extracted from the carcass. Finally, costs that must be incurred to convert ribs into final products will be as- signed directly to those products. This is the basic cost flow for joint products and by-products. 10-3 The Reasoning Behind Joint and By-product Costing As we will see in the next section, the allocation of costs to products at the split- off point is essentially arbitrary in nature. Although two standard methods are used, neither one leads to information that is useful for management decision making. Why, then, must the inventory accountant be concerned with the proper cost alloca- tion methodology for joint products and by-products? Exhibit 10-1 Multiple Split-Off Points for Joint Products and By-products Additional Processing Flavored Rib Split-off Point Products Ribs Remainder Full Carcass of Carcass Viscera Split-Off Point
Joint and By-Product Costing / 143 Because there are accounting and legal reasons for doing so. Generally accepted accounting principles (GAAP) require that costs be assigned to products for inven- tory valuation purposes. Although the costs incurred by a production process up to the split-off point cannot be clearly assigned to a single product, it is still neces- sary to find some reasonable allocation method for doing so, in order to obey the accounting rules. Otherwise, all costs incurred up to the split-off point could rea- sonably be charged off directly to the cost of goods sold as an overhead cost, which would result in enormous overhead costs and few direct costs (only those incurred after the split-off point). The logic used for allocating costs to joint products and by-products has less to do with some scientifically derived allocation method and more with finding a quick and easy way to allocate costs that is reasonably defensible (as we will see in the next section). The reason for using simple methodologies is that the promulgators of GAAP realize there is no real management use for allocated joint costs—they cannot be used for determining break-even points, setting optimal prices, or figur- ing out the exact profitability of individual products. Instead, they are used for any of the following purposes, which are more administrative in nature: Inventory valuation. It is possible to manipulate inventory levels (and therefore the reported level of income) by shifting joint cost allocations toward those prod- ucts that are stored in inventory. This practice is obviously discouraged, because it results in changes to income that have no relationship to operating conditions. Nonetheless, one should be on the lookout for the deliberate use of allocation methods that will alter the valuation of inventory. Income reporting. Many organizations split their income statements into sub- levels that report on profits by product line or even individual product. If so, joint costs may make up such a large proportion of total production costs that these income statements will not include the majority of production costs, un- less they are allocated to specific products or product lines. Transfer pricing. A company can alter the prices at which it sells products among its various divisions, so that high prices are charged to those divisions located in high-tax areas, resulting in lower reported levels of income tax against which those high tax rates can be applied. A canny inventory accounting staff will choose the joint cost allocation technique that results in the highest joint costs being assigned to products being sent to such locations (and the reverse for low-tax regions). Bonus calculations. Manager bonuses may depend on the level of reported prof- its for specific products, which in turn are partly based on the level of joint costs allocated to them. Thus, managers have a keen interest in the calculations used to assign costs, especially if some of the joint costs can be dumped onto products that are the responsibility of a different manager. Cost-plus contract calculations. Many government contracts are based on the reimbursement of a company’s costs, plus some predetermined margin. In this situation, it is in a company’s best interests to ensure that the largest possible
144 / Inventory Accounting proportion of joint costs are assigned to any jobs that will be reimbursed by the customer, while the customer will be equally interested, but because of a desire to reduce the allocation of joint costs. Insurance reimbursement. If a company suffers damage to its production or inventory areas, some finished goods or work-in-process inventory may have been damaged or destroyed. If so, it is in the interests of the company to fully allocate as many joint costs as possible to the damaged or destroyed stock, so that it can receive the largest possible reimbursement from its insurance provider. Next, we will look at the two most commonly used methods for allocating joint costs to products, which are based on product revenues for one method and gross margins for the other. 10-4 Cost Allocation Methodologies Although several cost allocation methodologies have been proposed in the account- ing literature, only two methods have gained widespread acceptance. The first is based on the sales value of all joint products at the split-off point. To calculate it, the inventory accountant compiles all costs accumulated in the production process up to the split-off point, determines the eventual sales value of all products created at the split-off point, and then assigns these costs to the products based on their rel- ative values. If there are by-products associated with the joint production process, they are considered to be too insignificant to be worthy of any cost assignment, al- though revenues gained from their sale can be charged against the cost of goods sold for the joint products. This is the simplest joint cost allocation method, and it is particularly attractive, because the inventory accountant needs no knowledge of any production processing steps that occur after the split-off point. This different treatment of the costs and revenues associated with by-products can lead to profitability anomalies at the product level. The trouble is that the deter- mination of whether a product is a by-product or not can be subjective; in one com- pany, if a joint product’s revenues are less than 10% of the total revenues earned, then it is a by-product, whereas another company might use a 1% cutoff figure in- stead. Because of this vagueness in accounting terminology, one company may as- sign all of its costs to just those joint products with an inordinate share of total revenues, and record the value of all other products as zero. If a large quantity of these by-products were to be held in stock at a value of zero, the total inventory val- uation would be lower than another company would calculate, simply because of their definition of what constitutes a by-product. A second problem with the treatment of by-products under this cost allocation scenario is that by-products may only be sold off in batches, which may only occur once every few months. This can cause sudden drops in the cost of joint products in the months when sales occur, because these revenues will be subtracted from their cost. Alternately, joint product costs will appear to be too high in those periods when there are no by-product sales. Thus, one can alter product costs through the timing of by-product sales.
Joint and By-Product Costing / 145 A third problem related to by-products is that the revenues realized from their sale can vary considerably, based on market demand. If so, these altered revenues will cause abrupt changes in the cost of those joint products against which these revenues are netted. It certainly may require some explaining by the inventory ac- countant to show why changes in the price of an unrelated product caused a change in the cost of a joint product! This can be a difficult concept for a nonaccountant to understand. The best way to avoid the three issues just noted is to avoid the designation of any product as a by-product. Instead, every joint product should be assigned some proportion of total costs incurred up to the split-off point, based on their total po- tential revenues (however small they may be), and no resulting revenues should be used to offset other product costs. By avoiding the segregation of joint products into different product categories, we can avoid a variety of costing anomalies. The second allocation method is based on the estimated final gross margin of each joint product produced. The calculation of gross margin is based on the revenue that each product will earn at the end of the entire production process, less the cost of all processing costs incurred from the split-off point to the point of sale. This is a more complicated approach, because it requires the inventory accountant to ac- cumulate additional costs through the end of the production process, which in turn requires a reasonable knowledge of how the production process works and where costs are incurred. Although it is a more difficult method to calculate, its use may be mandatory in those instances where the final sale price of one or more joint products cannot be determined at the split-off point (as is required for the first al- location method), thereby rendering the other allocation method useless. The main problem with allocating joint costs based on the estimated final gross margin is that it can be difficult to calculate if there is a great deal of customized work left between the split-off point and the point of sale. If so, it is impossible to determine in advance the exact costs that will be incurred during the remaining production process. In such a case, the only alternative is to make estimates of expected costs that will be incurred, base the gross margin calculations on this in- formation, and accept the fact that the resulting joint cost allocations may not be provable, based on the actual costs incurred. The two allocation methods described here are easier to understand with an ex- ample, which is shown in Exhibit 10-2. In the exhibit, we see that $250 in joint costs have been incurred up to the split-off point. The first allocation method, based on the eventual sale price of the resulting joint products, is shown beneath the split-off point. In it, the sale price of the by-product is ignored, leaving a revenue split of 59% and 49% between products A and B, respectively. The joint costs of the process are allocated between the two products based on this percentage. The second allocation method, based on the eventual gross margins earned by each of the products, is shown to the right of the split-off point. This calculation includes the gross margin on sale of product C, which was categorized as a by- product, and therefore ignored, in the preceding calculation. This calculation results in a substantially different sharing of joint costs between the various prod- ucts than we saw for the first allocation method, with the split now being 39%,
Exhibit 10-2 Example of Joint Cost Allocation Methodologies Costs Margin Percent Final Sale Final After After of Total Cost Point Revenue Split-Off Split-Off Revenues Allocation Product A $ 12.00 $ 8.50 $ 3.50 39% $ 97.22 Split-off Point Product B 8.25 3.00 5.25 58% 145.83 Total Costs Incurred = $250.00 Product C 0.25 — 0.25 3% 6.94 146 $ 20.50 $ 11.50 $ 9.00 100% $ 250.00 Percent Final of Total Cost Joint Cost Allocation Based on Gross Name Type Revenue Revenues Allocation Margin After Split-Off Point Product A Joint $ 12.00 59% $ 148.15 Product B Joint 8.25 41% 101.85 Product C Byproduct — 0% — $ 20.25 100% $ 250.00 Joint Cost Allocation Based on Estimated Sales Value at the Split-off Point
Joint and By-Product Costing / 147 58%, and 3% between products A, B, and C, respectively. The wide swing in al- located amounts between the two methods can be attributed to the different bases of allocation: the first is based on revenue, whereas the second is based on gross margins. 10-5 Pricing of Joint Products and By-products The key operational issue for which joint cost allocations should be devoutly ig- nored is in the pricing of joint products and by-products. The issue here is that the allocation used to assign a cost to a particular product does not really have any bearing on the actual cost incurred to create the product—either method for split- ting costs between multiple products, as noted in the last section, cannot really be proven to allocate the correct cost to any product. Instead, we must realize that all costs incurred up to the split-off point are sunk costs that will be incurred, no matter what combination of products are created and sold from the split-off point forward. Because everything before the split-off point is considered to be a sunk cost, pricing decisions are only concerned with those costs incurred after the split-off point, because these costs can be directly traced to individual products. In other words, incremental changes in prices should be based on the incremental increases in costs that accrue to a product after the split-off point. This can result in costs being assigned to products that are inordinately low, because there may be so few costs incurred after the split-off point. This can be in response to competitive pressures or because it only seems necessary to add a modest markup percentage to the incre- mental costs incurred after the split-off point. If these prices are too low, then the revenues resulting from the entire production process may not be sufficiently high for the company to earn a profit. The best way to ensure that pricing is sufficient for a company to earn a profit is to create a pricing model for each product line. This model, as shown in Exhibit 10-3, itemizes the types of products and their likely selling points, as well as the variable costs that can be assigned to them subsequent to the split-off point. Thus far, the exhibit results in a total gross margin that is earned from all joint and by- product sales. Then we add up the grand total of all sunk costs that were incurred before the split-off point and subtract this amount from the total gross margin. If the resulting profit is too small, then the person setting prices will realize that indi- vidual product prices must be altered in order to improve the profitability of the entire cluster of products. Also, by bringing together all of the sales volumes and price points related to a single production process, one can easily see where pricing must be adjusted in order to obtain the desired level of profits. In the example, we must somehow increase the total profit by $3.68 in order to avoid a loss. A quick perusal of the exhibit shows us that two of the products—the viscera and pituitary gland—do not generate a sufficient amount of throughput to cover this loss. Ac- cordingly, the sales staff should concentrate the bulk of its attention on the repric- ing of the other three listed products, in order to eliminate the operating loss. This format can be easily adapted for use for entire reporting periods or pro- duction runs, rather than for a single unit of production (as was the case in the last
148 / Inventory Accounting Exhibit 10-3 Pricing Model for Joint and By-product Pricing Product Incremental Throughput/ Total Name Price/ Unit Cost/ Unit Unit No. of Sales Units Throughput Viscera $.40 $.10 $.30 1 $.30 Barbequed ribs 3.00 1.80 1.20 4 4.80 Flank steak 5.50 1.05 4.35 2 8.70 Quarter steak 4.25 1.25 3.00 4 12.00 Pituitary gland 1.00 .48 .52 1 .52 Total throughput $26.32 Total sunk costs $30.00 Net profit/ loss –$3.68 exhibit). To do so, we simply multiply the number of units of joint products or by- products per unit by the total number of units to be manufactured during the period, and enter the totals in the far right column of the same format just used in Exhibit 10-3. The advantage of using this more comprehensive approach is that a production scheduler can determine which products should be included in a production run (assuming that more than one product is available) in order to generate the largest possible throughput.
11 Obsolete Inventory 11-1 Introduction Obsolete inventory is any inventory for which there is no longer any use, either through inclusion in viable manufactured goods or by direct sale to customers. Generally accepted accounting principles (GAAP) state that obsolete inventory must be written off as soon as it is identified. Given the substantial level of inter- pretation that can be put on the “obsolete inventory” designation, it is evident that this subject area can have a large adverse impact on profitability. In this chapter, we review how to find obsolete inventory, how to dispose of it in the most profitable manner, how much expense to recognize, and how to prevent it from occurring. 11-2 Locating Obsolete Inventory There are several techniques for locating obsolete inventory, as discussed in this section. However, be sure to gain the commitment of upper management to this search first; otherwise, the scope of the resulting expense (which can be substantial) may lead to multiple rounds of questions regarding how the company could have found itself saddled with so much obsolete inventory, all of which must be written off as soon as it is discovered. Conducting a search for obsolete inventory may meet with a particular level of resistance if the management team is being awarded sig- nificant profit-based bonuses. If so, consider addressing the prevention of incom- ing obsolete inventory instead, which may reduce inventory levels over the long term, although it will not address the existing obsolete inventory. It is certainly encouraging to see a manager eliminate obsolete inventory, but a common problem is to see some items disposed of that were actually needed, possi- bly for short-term production requirements, but also for long-term service parts or substitutes for other items. In these cases, the person eliminating inventory will likely be castigated for causing problems that the logistics staff must fix. A good solution is to form a Materials Review Board (MRB). The MRB is composed of rep- resentatives from every department having any interaction with inventory issues— 149
150 / Inventory Accounting accounting, engineering, logistics, and production. For example, the engineering staff may need to retain some items that they are planning to incorporate into a new design, while the logistics staff may know that it is impossible to obtain a rare part, and so prefer to hold onto the few items left in stock for service parts use. It can be difficult to bring this disparate group together for obsolete inventory reviews, so one normally has to put a senior member of management in charge to force meetings to occur, while also scheduling a series of regular inventory review meetings well in advance. Meeting minutes should be written and disseminated to all group members, identifying which inventory items have been mutually declared obsolete. If this approach still results in accusations that items have been improp- erly disposed of, then the group can also resort to a sign-off form that must be completed by each MRB member before any disposition can occur. However, ob- taining a series of sign-offs can easily cause lengthy delays or the loss of the sign- off form, and is therefore not recommended. A simpler approach is to use a negative approval process whereby items will be dispositioned as of a certain date unless an MRB member objects. The MRB is not recommended for low-inventory situations, as can arise in a just-in-time (JIT) environment, because an MRB tends to act too slowly for employees who are used to a fast-moving JIT system. The simplest long-term way to find obsolete inventory without the assistance of a computer system is to leave the physical inventory count tags on all inventory items following completion of the annual physical count. The tags taped to any items used during the subsequent year will be thrown away at the time of use, leav- ing only the oldest unused items still tagged by the end of the year. One can then tour the warehouse and discuss with the MRB each of these items to see if an obso- lescence reserve should be created for them. However, tags can fall off or be ripped off inventory items, especially if there is a high level of traffic in nearby bins. Extra taping will reduce this issue, but it is likely that some tag loss will occur over time. Even a rudimentary computerized inventory tracking system is likely to record the last date on which a specific part number was removed from the warehouse for production or sale. If so, it is an easy matter to use a report writer to extract and sort this information, resulting in a report listing all inventory, starting with those products with the oldest “last used” date. By sorting the report with the oldest last- usage date listed first, one can readily arrive at a sort list of items requiring further investigation for potential obsolescence. However, this approach does not yield sufficient proof that an item will never be used again, because it may be an essen- tial component of an item that has not been scheduled for production in some time, or a service part for which demand is low. A more advanced version of the last used report is shown in Exhibit 11-1. It compares total inventory withdrawals to the amount on hand, which by itself may be sufficient information to conduct an obsolescence review. It also lists planned usage, which calls for information from a material requirements planning system and which informs one of any upcoming requirements that might keep the MRB from otherwise disposing of an inventory item. An extended cost for each item is also listed, in order to give report users some idea of the write-off that might occur if an item is declared obsolete. In the exhibit, the subwoofer, speaker bracket, and
Obsolete Inventory / 151 Exhibit 11-1 Inventory Obsolescence Review Report Last Item Quantity Year Planned Extended Description No. Location on Hand Usage Usage Cost Subwoofer case 0421 A-04-C 872 520 180 $9,053 Speaker case 1098 A-06-D 148 240 120 1,020 Subwoofer 3421 D-12-A 293 14 0 24,724 Circuit board 3600 B-01-A 500 5,090 1,580 2,500 Speaker, bass 4280 C-10-C 621 2,480 578 49,200 Speaker bracket 5391 C-10-C 14 0 0 92 Wall bracket 5080 B-03-B 400 0 120 2,800 Gold connection 6233 C-04-A 3,025 8,042 5,900 9,725 Tweeter 7552 C-05-B 725 6,740 2,040 5,630 wall bracket appear to be obsolete based on prior usage, but the planned use of more wall brackets would keep that item from being disposed of. If a computer system includes a bill of materials, there is a strong likelihood that it also generates a “where used” report, listing all of the bills of material for which an inventory item is used. If there is no “where used” listed on the report for an item, it is likely that a part is no longer needed. This report is most effective if bills of material are removed from the computer system or deactivated as soon as products are withdrawn from the market; this approach more clearly reveals those inventory items that are no longer needed. An additional approach for determining whether a part is obsolete is reviewing engineering change orders. These documents show those parts being replaced by different ones, as well as when the changeover is scheduled to take place. One can then search the inventory database to see how many of the parts being replaced are still in stock, which can then be totaled, yielding another variation on the amount of obsolete inventory on hand. A final source of information is the preceding period’s obsolete inventory re- port. Even the best MRB will sometimes fail to dispose of acknowledged obsolete items. The accounting staff should keep track of these items and continue to no- tify management of those items for which there is no disposition activity. In order to make any of these review systems work, it is necessary to create policies and procedures as well as ongoing scheduled review dates. By doing so, there is a strong likelihood that obsolescence reviews will become a regular part of a company’s activities. In particular, consider a Board-mandated policy to con- duct at least quarterly obsolescence reviews, which gives management an oppor- tunity to locate items before they become too old to be disposed of at a reasonable price. Another Board policy should state that management will actively seek out and dispose of work-in-process or finished goods with an unacceptable quality level. By doing so, goods are kept from being stored in the warehouse in the first place, so the MRB never has to deal with it at a later date.
152 / Inventory Accounting 11-3 Disposing of Obsolete Inventory As soon as obsolete inventory is identified, GAAP mandates that it be written off at once. However, this only applies to the unrecoverable portion of the inventory, so one should make a strong effort to earn some compensation from an inventory dis- position. This section outlines several disposition possibilities, beginning with full- price sales and moving down through options having progressively lower returns. In some situations, one can recover nearly the entire cost of excess items by ask- ing the service department to sell them to existing customers as replacement parts. This approach is especially useful when the excess items are for specialized parts that customers are unlikely to obtain elsewhere, because these sales can be pre- sented to customers as valuable replacements that may not be available for much longer. Conversely, this approach is least useful for commodity items or those sub- ject to rapid obsolescence or having a short shelf life. It is possible that some parts should be kept on hand for a few years, to be sold or given away as warranty replacements. This will reduce the amount of obsoles- cence expense and also keeps the company from having to procure or remanufac- ture parts at a later date in order to meet service/repair obligations. The amount of inventory to be held in this service/repair category can be roughly calculated based on the company’s experience with similar products, or with the current product if it has been sold for a sufficiently long period. Any additional inventory on hand exceeding the total amount of anticipated service/repair parts can then be disposed of. Of particular interest is the time period over which management anticipates stor- ing parts in the service/repair category. There should be some period over which the company has historically found that parts are required, such as five or ten years. Once this predetermined period has ended, a flag in the product master file should trigger a message indicating that the remaining parts can be eliminated. Before doing so, management should review recent transactional experience to see if the service/repair period should be extended or if it is now safe to eliminate the re- maining stock. Another possibility is to return the goods to the original supplier. Doing so will likely result in a restocking fee of 15% to 20%, which is still a bargain for otherwise useless goods. Rather than buying back parts for cash, many suppliers will only issue a credit against future purchases. This option becomes less likely if the company has owned the goods for a long time, because the supplier may no longer have a need for them stock them at all. Of course, this approach fails if the supplier will only issue a credit and the company has no need for other parts sold by the supplier. It may be possible to sell goods online through an auction service. The best- known site is eBay, although there are other sites designed exclusively for the disposition of excess goods, such as www.salvagesale.com. These sites are more proactive in maintaining contact with potential buyers within specific commodity categories, and so can sometimes generate higher resale prices. A poor way to sell off excess inventory to salvage contractors is to allow them to pick over the items for sale, only selecting those items they are certain to make
Obsolete Inventory / 153 a profit on. By doing so, the bulk of the excess inventory will still be parked in the warehouse when the contractors are gone. Instead, divide the inventory into batches, each one containing some items of value, which a salvage contractor must purchase in total in order to obtain that subset of items desired. Then have the con- tractors bid on each batch. Although the total amount of funds realized may not be much higher than would have been the case if the contractors had cherry-picked the inventory, they will take on the burden of removing the inventory from the ware- house, thereby allowing the company to avoid disposal expenses. There are some instances where a company can donate excess inventory to a charity. By doing so, it can claim a tax deduction for the book value of the donated items. This will not generate any cash flow if the company has no reportable in- come, but the deduction can contribute to a net operating loss carry-forward that can be carried into a different tax reporting year. If this approach looks viable, re- quest a copy of nonprofit status from the receiving entity, proving that it has been granted nonprofit status under section 501(c)(3) of the Internal Revenue Service tax code. Finally, even if there is no hope of obtaining any form of compensation for ob- solete goods, strongly consider throwing them in the dumpster. By doing so, there will be more storage space in the warehouse, the space to be allocated to other uses. Furthermore, the amount of inventory insurance coverage will be less, resulting in a smaller annual insurance premium. Depending on the local tax jurisdiction, one can also avoid paying a property tax on the inventory that has been disposed of. In addition, the number of inventory items to track in the warehouse database can be reduced, which can lead to a reduction in the number of cycle counting hours re- quired per day to review the entire inventory on a recurring basis. 11-4 Expense Recognition for Obsolete Inventory In brief, the proper expense recognition procedure for obsolete inventory is to de- termine the most likely disposition value for the targeted items, subtract this value from the book value of the obsolete inventory, and set aside the difference as a re- serve. As the obsolete inventory is actually disposed of or estimates in the dispo- sition values change, adjust the reserve account to reflect these alterations. For example, a review of the Presto Computer Company’s inventory reveals that it has $100,000 of laptop computer hard drives that it cannot sell. However, it believes there is a market for the drives through a reseller in Africa, but only at a sale price of $20,000. Accordingly, the Presto controller recognizes a reserve of $80,000 with the following journal entry: Debit Credit Cost of goods sold $80,000 Reserve for obsolete inventory $80,000
154 / Inventory Accounting After finalizing arrangements with the African reseller, the actual sale price is only $19,000, so the controller completes the transaction with the following entry, rec- ognizing an additional $1,000 of expense: Debit Credit Reserve for obsolete inventory $80,000 Cost of goods sold $1,000 Inventory $81,000 Sounds like a simple, mechanical process, doesn’t it? It is not. The first problem is that one can improperly alter a company’s reported financial results just by alter- ing the timing of actual dispositions. For example, if a manager knows he can re- ceive a higher-than-estimated price when selling old inventory, he can accelerate or delay the sale in order to drop some gains into a reporting period where the extra re- sults are needed. This is unlikely to be a significant problem if the reserve is small, but it is a substantial risk if the reverse is the case. For example, the Presto Computer Company has set aside an obsolescence reserve of $25,000 for laptop computer fans. However, in January, the purchasing manager knows that the resale price for fans has plummeted, so the real reserve should be closer to $35,000, which would call for the immediate recognition of an additional $10,000 of expense. However, because this would result in an overall loss in Presto’s financial results in January, he waits until April, when Presto has a profitable month, and completes the sale at that time, thereby delaying the additional obsolescence loss until the point of sale. A second problem is the reluctance of management to suddenly drop a large expense reserve into the financial statements, which may disturb outside investors and creditors. Managers have a tendency instead to recognize small incremental amounts, thereby making it look as though obsolescence is a minor problem. There is no ready solution to this problem, because GAAP clearly mandates that all obsolete inventory be written off at once. It is a rare accountant who does not enter into a battle with management over this issue at some point during his or her career. A third problem is the shear size of an expense recognition if there has been a long time period between obsolescence reviews. A review usually occurs at the end of the fiscal year, when this type of inventory is supposed to be investigated and written off, usually in conjunction with the auditor’s review or the physical inven- tory count (or both). If this write-off has not occurred in previous years, the cumu- lative amount can be startling, which can result in the departure of the materials manager and/or the controller on the grounds that they should have known about the problem. There are three ways to keep a large write-off from occurring. First, conduct frequent obsolescence reviews to keep large write-offs from building up. Second, create an obsolescence expense reserve as part of the annual budget, and encourage the MRB to use it all. Under this approach, one can usually count on the warehouse manager to throw out the maximum possible amount of stock on the first
Obsolete Inventory / 155 day when the new budget takes effect. Third, implement some of the approaches described in the next section to prevent inventory from becoming obsolete. A final expense recognition issue is that senior management simply may not be- lieve the MRB when they arrive at an extremely high obsolescence reserve, and management may reject the recommended expense recognition. Their presumed knowledge of the business will not allow them to consider that a large part of the inventory is no longer usable. If this is the case, consider bringing in consultants to conduct an independent evaluation of the inventory. Senior managers may need this second opinion before they will authorize a large obsolescence reserve. 11-5 Preventing Obsolete Inventory Thus far, we have only reviewed a variety of ways to locate, dispose of, and account for obsolete inventory. The real trick is to avoid all of those topics by ensuring that there is no obsolete inventory to begin with. This section addresses several ways to achieve this goal. A major source of obsolete inventory is excessive purchasing volumes. The purchasing department may be purchasing in large quantities in order to save itself the trouble of issuing a multitude of purchase orders for smaller quantities, or be- cause it can obtain lower prices by purchasing in large volumes. This problem can be avoided through the use of just-in-time purchasing practices, purchasing only those items authorized by a material requirements planning system, or by setting high inventory turnover goals for the materials management department. A well run purchasing department will use bills of material to determine the parts needed to build a product and then order them in the quantities specified in the bills. However, if a bill of material is incorrect, then the items purchased will either be the wrong ones or the correct ones but in the wrong quantities. To avoid this problem, the bill of materials should be audited regularly for accuracy. An addi- tional way to repair bills of material is to investigate why some kitted items are re- turned unused to the warehouse or additional items are requested by the production staff. These added transactions usually indicate incorrect bills of material. It is easy for a part to become obsolete if no one knows where it is. If it is buried in an odd corner of the warehouse, there is not much chance that it will be used up. To avoid this problem, there should be location codes in the inventory database for every part, along with continual cycle counting to ensure that locations are correct. A periodic audit of location codes will give management a clear view of the accu- racy of this information. When the marketing department investigates the possibility of withdrawing a product from sale, it often does so without determining how much inventory of both the finished product and its component parts remain on hand. At most, the market- ing staff only concerns itself with clearing out excess finished goods, because this can be readily identified. Those unique parts that are only used in the manufacture of a withdrawn product will then be left to gather dust in the warehouse and will eventually be sold off as scrap only after a substantial amount of time has passed.
156 / Inventory Accounting To avoid this situation, the engineering, marketing, production, and accounting managers should review all proposed product cancellations to determine how much inventory will be left “hanging” on the proposed cancellation date. The result may be a revised termination date designed to first clear out all remaining stocks. A related problem is poor engineering change control. If the engineering de- partment does not verify that old parts are completely used up before installing a new part in a product, then the remaining quantities of the old part will be rendered obsolete. To avoid this scenario, have the accounting, production, and engineering managers determine the best time to effect the change that will minimize the old stock. Furthermore, if there is an automatic ordering flag in the computer system, shut it off for any items being withdrawn from use through an engineering change order. Otherwise, the system will reorder parts that have been deliberately drawn down below their reorder points. Some products have limited shelf lives and must be thrown out if they are not used by a certain date. This certainly applies to all food products and can even be an issue with such other items as gaskets and seals, which will dry out over time. In a large warehouse with thousands of inventory items and only a small number of these limited-life products, it can be difficult to specially track them and ensure that they will be used before their expiration dates. A mix of changes must be implemented to ensure proper shelf life control. First, the computer system must have a record of the ending shelf life date for each item in the warehouse. This calls for a special field in the inventory record that is not present in many standard inventory systems, so one must either obtain standard software containing this feature or have the existing database altered to make this feature available. The receiving staff must be warned by the computer system upon the arrival of a limited-shelf-life item, so a flag must also be available in the item master file for this purpose. With both of these software changes in hand, one can use the computer system to warn of impending product obsolescence for specific items. A simpler variation is to still have a flag in the item master file warn of the arrival of limited-shelf-life items, but to then have the warehouse staff manually track the obsolescence problem from that point on. This means clearly tagging each item with its shelf life date, so anyone picking inventory can clearly see which items must be picked first. Although this solution is much less expensive, it relies on both the receiving staff and stock pickers to ensure that the oldest items are used first. A third variation is to use a gravity flow rack. This is a racking system set at a slight downward angle to the picker and containing rollers. Cartons of arriving items are loaded into the back of the rack, where they queue up behind cartons containing older items. Pickers then take the oldest items from the front of the rack. Because of this load-in-back, pick-in-front configuration, inventory is always used in a first-in, first-out manner, ensuring that the oldest items are always used first. This is an ex- cellent way to control item shelf life, because there is no conscious need to pick one item over another in order to use the oldest one first. Similar racking systems are available for pallet-sized loads. However, this system does not absolutely ensure that items will be used before their shelf life dates; if there are many items in front of an
Obsolete Inventory / 157 item in a gravity flow rack, or if demand is minimal, then the older item still will not be used in time. If one can identify any of these problems as being the cause of obsolescence, quantify the cost of each problem and aggressively push for any changes that will eliminate it.
12 Inventory Transactions 12-1 Introduction This chapter describes the most common inventory-related journal entries. The first section contains entries for goods in transit, beginning with the receipt of raw material and progressing through the various types of inventory to their eventual sale to customers. The second section contains entries listing common adjustments to inventory, including obsolescence, physical count adjustments, and abnormal scrap. The final block of entries shows how to shift indirect costs of various kinds into the overhead cost pool, and then how to allocate these costs back out to either the cost of goods sold or inventory. For each journal entry, there is a sample de- scription, as well as the most likely debit and credit for each account used within the entry. 12-2 Goods in Transit Record received goods. To increase inventory levels as a result of a supplier delivery. Debit Credit Raw materials inventory xxx Accounts payable xxx Move inventory to work-in-process. To shift the cost of inventory to the work-in- process category once production work begins on converting it from raw materials to finished goods. Debit Credit Work-in-process inventory xxx Raw materials inventory xxx 159
160 / Inventory Accounting Move inventory to finished goods. To shift the cost of completed inventory from work-in-process inventory to finished goods inventory. Debit Credit Finished goods inventory xxx Work-in-process inventory xxx Sell inventory. To record the elimination of the inventory asset as a result of a prod- uct sale, shifting the asset to an expense and also recording the creation of an ac- counts receivable asset to reflect an unpaid balance from the customer on sale of the product. Debit Credit Cost of goods sold xxx Finished goods inventory xxx Accounts receivable xxx Revenue xxx 12-3 Inventory Adjustments Adjust inventory for obsolete items: To charge an ongoing expense to the cost of goods sold that increases the balance in a reserve against which obsolete inventory can be charged (first entry). The second entry charges off specific inventory items against the reserve. Debit Credit Cost of goods sold xxx Obsolescence reserve xxx Obsolescence reserve xxx Raw materials inventory xxx Work-in-process inventory xxx Finished goods inventory xxx Adjust inventory to lower of cost or market. To reduce the value of inventory to a market price that is lower than the cost at which it is recorded in the company records. The second journal entry shows an alternative approach where the credit is made to an inventory valuation account instead, from which specific write-offs can be completed at a later date.